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Bitcoin: A Worthwhile Risk?


When Rhonda Kampert bought six bitcoins in 2013 she paid around $80 each and promptly forgot them. The young mother became preoccupied with raising her family and over time the bitcoins languished in her wallet, that is until 8 years later when on the 8th of November 2021 the price of bitcoin hit $67,556.83. Rhonda suddenly realised that her casual investment had turned out to be a financial windfall. However, her elation rapidly turned into despair when she couldn’t find her password credentials.


 

It turns out she is not alone, one estimate from crypto researchers suggests that out of the 18.9 million Bitcoins in circulation, as many as 3.7 million have been lost by owners due to problems with passwords.  A staggering 19.6% or at today’s value, $269.7 billion worth. Thankfully for Rhonda, for a fee, she was able to engage the use of hackers to successfully retrieve her wallet credentials.


Bitcoin, the pioneering cryptocurrency, has revolutionised the financial landscape since its inception by the elusive and anonymous individual known as Satoshi Nakamoto in 2009. As of 2024, Bitcoin has evolved from an obscure digital experiment to a global financial phenomenon that challenges traditional currency systems and investment models.

At its core, Bitcoin was created to address the limitations and flaws of traditional fiat money systems. Central to its philosophy is the concept of decentralisation. Traditional currencies are controlled by central banks and governments, which often lead to issues such as inflation, censorship, and lack of privacy. Bitcoin operates on a decentralised network of computers, which collectively validate and record transactions on a public ledger called the blockchain.


The blockchain is immutable and transparent, ensuring no single entity can alter transaction records. This decentralisation and transparency align with the broader ethos of giving power back to the people, reducing reliance on intermediaries, and promoting financial sovereignty. Additionally, Bitcoin's fixed supply of 21 million coins introduces scarcity, akin to precious metals like gold, making it a seemingly attractive store of value.


Bitcoins initial value was set by the now famous pizza transaction, frequently referred to as “Bitcoin Pizza Day”. Two pizzas were purchased in 2010 for 10,000 BTC. The equivalent value for these pizzas was around $41.00 at the time. The intervening bull run, which we can now all only dream about being on, has seen the price of bitcoin hit in excess of $73,000. Had the Pizza parlour decided to hold the bitcoin they were paid for the two pizzas until today, the pizzas would be valued at the time of writing this article at an astronomical $714.8 million.


Bitcoin, and cryptocurrencies in general, have provoked diverse opinions in financial literature and academic discourse, particularly concerning their roles as investment vehicles and speculative assets. From an investment viewpoint, Bitcoin and cryptocurrencies are often discussed for their potential to act as a hedge against traditional financial markets. Because Bitcoin possesses characteristics similar to gold, it can serve as a potential safe haven, particularly during times of economic uncertainty. Bitcoin exhibits low correlations with traditional asset classes like stocks and bonds, and thus provides a non-correlated risk hedge that makes it a strong candidate for portfolio diversification.


In countries with unstable fiat currencies, Bitcoin's decentralised nature can provide a form of financial stability for retail investors. However, it is also important to note that Bitcoin's demonstrated price volatility can pose considerable risks, often outstripping its potential utility as a stable store of value particularly over the short term.

Many market participants view Bitcoin primarily as a speculative asset rather than a sound investment. They argue that Bitcoin's extreme volatility is driven largely by speculative trading, with prices frequently detached from any fundamental value. Unfettered speculation driven by the Fear of Missing Out (FOMO) frequently propels retail investors into high-risk positions, exacerbating market volatility and speculation cycles. This often creates bubbles, over-exposing retail investors to the risk of significant losses in the event of market corrections.


Yet given Bitcoins performance over the last decade it presents potential retail investors with an investment conundrum. Retail investors often exhibit a tendency to chase past performance, a phenomenon starkly visible in the cryptocurrency market. This behaviour is exacerbated by the intense media coverage and public discourse surrounding cryptocurrencies, creating an environment where retail investors are apt to prioritise potential short-term gains over long-term strategic investment.


Yet the evidence for investing in Bitcoin remains compelling. Over the last 13 years it has demonstrated a compound annual growth rate (CAGR) of 140%, making it the highest yield investment in history. It seems logical that the pre-determined supply distribution of Bitcoin will cause its value to rise as demand for it increases. Especially with the existing trend by Central Banks of currency debasement of fiat currency.


For many Investors volatility has been a deterrent. For the common retail investor, volatility seems to overwhelm logic and is regarded by most as a plague, which is different to wealth creators who seek it out. Data has shown that the price of bitcoin is more influenced by smaller investors and high-speed traders in the short term who profit from market volatility, not direction.

The best measure of gauging the effect of the risk volatility poses to investors is by the use of the Sharpe ratio. This ratio uses the asset’s volatility to measure risk-adjusted returns. It calculates how much excess return an investment generates per unit of risk taken. Bitcoins current Sharpe ratio is 5.59, any score over 1 is considered good. For context S&P500 Sharpe ratio is 0.44, Apple 0.55, Tesla -0.04 and the best performing equity NVIDIA is 4.96. This implies Bitcoin generated more returns per unit of risk than NVIDIA. On that basis it seems imprudent for Investors not to incorporate Bitcoin into their investment portfolios.


Some Analysts have predicted that the price of a Bitcoin will reach $1 million by the end of the decade. The theoretical basis for this forecast is institutional acceptance of Bitcoin as an effective store of value and the ease by which it can be adopted as a unit of exchange. Not everyone agrees, some see Bitcoin price action as a bubble likely to  propagate a financial l calamity.

Emmanuel Derman a renowned physicist, financial theorist, and author wrote in his book, My Life As A Quant, “The more confident we become in our theoretical knowledge, the closer we become to provoking a disaster”.  Catastrophes he posits, “strike when people allow theories to take a life of their own…”

1 Comment


Guest
Jun 06

Very good article

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